Nov. 21 (Bloomberg) -- You’ve probably never heard of
Taunus Corp., but according to the Federal Reserve, it’s the
U.S.’s eighth-largest bank holding company. Taunus, it turns
out, is the North American subsidiary of Germany’s Deutsche Bank
AG, with assets of just over $380 billion.

Deutsche Bank holds a large amount of European government
and bank debt; it also has considerable exposure to lingering
real estate problems in the U.S. The bank, therefore, could
become a conduit for risk between the two economies. But which
way is Deutsche Bank more likely to transmit danger -- to or
from the U.S.?

By any measure, Deutsche Bank is a giant. Its assets at the
end of September totaled 2.28 trillion euros (according to the
bank’s own website), or $3.08 trillion. In the latest ranking
from The Banker, which uses 2010 data, Deutsche was the second-largest bank in the world by assets, behind only BNP Paribas SA.

The German bank, however, is thinly capitalized. Its total
equity at the end of the third quarter was only 51.9 billion
euros, implying a leverage ratio (total assets divided by
equity) of almost 44. This is up from the second quarter, when
leverage was about 36 (assets were 1.849 trillion euros and
capital was 51.678 euros.)

Even by modern standards, this is very high leverage.
JPMorgan Chase & Co. has a balance sheet about 20 percent
smaller than Deutsche Bank’s, but more than twice as much Tier 1
capital, an important indicator of a bank’s financial strength.
Bank of America Corp., whose weakness is a serious worry in the
U.S. today, has twice Deutsche’s capital. (These comparisons use
The Banker’s ranking of the top 25 banks and aren’t adjusted for
differences between U.S. and European accounting rules.)

Healthy Capital Ratio

Globally, Deutsche’s capital ratios are relatively healthy,
judging by the banking industry’s standard measures. At the end
of the third quarter, its Tier 1 capital ratio was 13.8 percent
(up from 12.3 percent at the end of 2010) and its core Tier 1,
which excludes hybrid debt that can convert into equity, was
10.1 percent.

How does such a highly leveraged bank become “well-capitalized”? The answer is that “risk-weighted assets” were
337.6 billion euros as of Sept. 30. But what is a low risk-weight asset in the European context today? Incredibly, it is
sovereign debt, which of course is far from riskless at the
moment.

Perhaps Deutsche Bank holds mostly German government debt,
which still has safe-haven value. But it’s likely that Deutsche
also holds a significant amount of Italian and French government
bonds.

Still, the bigger risks are probably in the U.S. Deutsche
Bank is a significant trustee for mortgages, having been heavily
involved in the issuance and distribution of mortgage-backed
securities during the housing bubble. Yves Smith, writing on the
nakedcapitalism.com blog, says Deutsche Bank is one of the
U.S.’s four biggest securitization trustees. Many questions on
whether paperwork was done properly and whether the rights of
investors have been protected hang over these trusts.

Let’s take a look just at Taunus Corp., named after a range
of mountains outside the parent bank’s Frankfurt headquarters.
The latest figures (from the Fed data, using the consolidated
financial statement at the end of the third quarter) show Taunus
with total equity capital of just $4.876 billion. This implies
an eye-popping leverage ratio of around 78.

Why would the Federal Reserve and the new council of
regulators known as the Financial Stability Oversight Council
allow Deutsche Bank to operate in the U.S. with sky-high
leverage -- with its huge implied risk to the rest of the
financial system? Presumably, in the past, U.S. authorities have
taken the view that Deutsche Bank had a strong enough balance
sheet worldwide that more capital could be provided to its
American subsidiary, if needed.

Troubling Questions

Such a presumption now seems questionable, at best. Earlier
this year, Bloomberg News reported that Taunus needed almost $20
billion of additional funds to meet U.S. capital standards, and
that Deutsche Bank was trying to declassify Taunus as a bank-holding company to avoid capital requirements entirely. It’s
unclear where this process now stands, but it’s also not obvious
how declassification would help U.S. or global financial
stability. Financial reform advocates hopefully will press hard
on this issue.

All of this raises troubling questions. Have U.S. bank
supervisors really satisfied themselves, through onsite
inspections, that Deutsche Bank’s risk weights accurately
reflect market conditions and the increasing structural weakness
of the euro area? Can U.S. regulators document their
satisfaction beyond the materials produced for the European
Banking Authority, which earlier this year oversaw stress tests
that pronounced now-collapsed Dexia as well-capitalized?
(Actually, Dexia had stronger capital ratios than Deutsche
Bank.)

In their prescient, pre-crisis book, “Too Big To Fail”
(not to be confused with the more recent Andrew Ross Sorkin book
of the same title), Gary H. Stern and Ron J. Feldman, in 2004
nailed the incentive distortions that encouraged risk-taking and
brought the financial sector to its knees. No one else came
close to them in getting this right. Included in their analysis
are examples of banks that could have been regarded as having
moral hazard issues because of their size. Deutsche Bank is No.
4 on their list of large, complex banking organizations by asset
size.

This dog did not bark during the 2008 crisis, partly
because most foreign governments were seen as having strong
enough balance sheets to back their banks’ worldwide operations.
But this is no longer necessarily true for euro-area
governments.

Even in 2008-2009, this may have been illusory. According
to published reports, Deutsche Bank received considerable
assistance from the Federal Reserve, including $11.8 billion
through the American International Group bailout and $2 billion
through the Fed’s discount window. Deutsche was also among the
largest users of the Fed’s mortgage-backed securities purchase
program.

Asking for Trouble

Deutsche Bank and, if necessary, the German government
should be required to inject substantially more capital into
Taunus. Allowing business as usual is asking for trouble,
particularly as Deutsche wants to remain focused on relatively
risky investment banking. Recently it named as chairman Paul
Achleitner, the finance director at Allianz SE, the German
insurance company, and an ex-Goldman Sachs executive, worrying
even some of its shareholders.

This would be a good time for Congress to dig more deeply
into the risks that Deutsche Bank poses to financial stability
in the U.S. and around the world.

(Simon Johnson, who served as chief economist at the
International Monetary Fund in 2007 and 2008, and is now a
professor at the MIT Sloan School of Management and a senior
fellow at the Peterson Institute for International Economics, is
a Bloomberg View columnist. The opinions expressed are his own.)